Inflation Rate

The inflation rate measures the change in price level over time, and it's the reason a car would cost about 5 bucks in the 1900s, but now you need a small fortune for a popcorn and soda at the movie theater.

Inflation has to be measured relative to a base year, and often by measuring changes in prices of a standard basket of goods. On the other hand, measuring inflation today relative to 1900 might not make the most sense, because cars, phones, TVs, and a whole host of other common place modern inventions won't be included in the standard basket of goods from a century ago.

There are two forms of inflation: demand-pull and cost-push. As the aggregate demand increases, both economic output and price level increase, pushing up the inflation rate. This relationship is the basis of the Phillips curve. On the other hand, when input costs increase for companies, they drive up prices to maintain their profit margins, which also increases inflation. Cost-push inflation lowers economic output, and creates the particularly-difficult-to-deal-with stagflation.

Example:

You're ready to start your Primo Pizza Parlor, but you need money for a pizza oven, ingredients, workers, a store, and a whole host of other things. So you go to a bank, apply for a loan for $100,000, and promise to pay it back in 5 years. The bank says, "Sure, we'll give you the dough, but you'll have to pay interest on it."

The interest you pay helps account for the expected rate of inflation, because when you give back the $100,000 in 5 years, it won't be worth as much.